Shares of GameStop (GME -3.52%) fell by double digits after hours on Wednesday, following the video game retailer's release of its second-quarter earnings results. The beleaguered business, suffering from a double whammy of the end of the current console cycles and the increasing digital delivery of video games, reported results that were worse than expected.

Sales fell 26.7% from the year-ago quarter as same-store sales fell by 12.7%, with results hurting from the late console cycle as well as store closures in the quarter, which spanned May through July. Though e-commerce sales grew 800%, that doesn't appear to be enough to offset the various headwinds GameStop is facing. Adjusted EBITDA losses increased from $19.9 million to $62.4 million, and net losses grew from $32 million to $91.2 million.

And yet despite these terrible-looking numbers, GameStop managed to generate $192.8 million in operating cash flow and $181.9 million in free cash flow. That's fairly striking, considering its market capitalization is only about $425 million. So how did GameStop do it?

A husband wife and son play video games together.

Image source: Getty Images.

Harvesting inventory

The biggest driver of GameStop's cash flow last quarter, and really all of this year, has been the company's selling off of inventory without replenishing it. During the quarter, it harvested $198.2 million from selling inventory without replacing it, and increased its accounts payable by $80.4 million while increasing its taxes payable by $47.5 million. In another boost to the cash levels (but one which isn't included in free cash flow), GameStop also sold some of its real estate in a sale-leaseback transaction, adding another $43.2 million in liquidity.

As a result, the company's cash hoard increased to $735.1 million against just $472.2 million of short- and long-term debt. Given that GameStop now has a net cash level of $262.9 million, which is more than half the company's market capitalization, it seems really cheap in relation to its balance sheet.

But more inventory is coming

However, investors shouldn't expect all that cash to be available for things like buybacks or paying down debt right now. GameStop will eventually have to restock its inventory in preparation for the new PlayStation and Xbox consoles, which will be coming out during the holiday season. Since we are at the very end of the life of the prior generation's seven-year-old consoles, GameStop had the luxury of selling off older consoles and console games this quarter before it has to restock for the holidays.

In addition, it will probably have another down quarter spanning August, September, and October before the holiday launches. The current weak results also suffered from a lack of new software games, many of which got pushed out to later in the year. Basically, it's possible there could be more cash burn in the next three months, not more cash flow.

Value stock or value trap?

GameStop is interesting right now since it's a cheap stock. On the other hand, many think the company may not survive the next few years, as e-commerce and digital gaming take over from physical games.

The new PlayStation and Xbox consoles will each have a disc drive in them, which is crucial for GameStop, though there will also be digital-only platforms launched in conjunction. If consumers flock to digital-only options, GameStop may be able to sell that hardware, but will miss out on sales of software and pre-owned games, which are much higher-margin businesses. As such, many justifiably believe that it may have a rough go of it this decade.

But there are also believers in the stock -- especially at its bargain price. At the end of August, it was revealed that RC Ventures, the investment firm set up by Chewy co-founder Ryan Cohen, had purchased 5.8 million shares of GameStop, giving it a 9% stake in the company. Another high-profile investor is Michael Burry, famous for his role in the book and movie The Big Short. Many continue to believe there will be an ongoing market for physical games, as digital downloads take up lots of memory and bandwidth, and trade-ins can make physical games cheaper in the long run if avid gamers trade in existing games for discounts on new ones.

Basically, there is a lot of controversy around GameStop right now, as the company's cost-cutting, turnaround efforts, solid balance sheet, cheap valuation, and new console launches are running into the headwinds of lower store traffic from the pandemic and the increased digitization of gaming.

Whichever side you land on, both bulls and bears should keep an open mind heading into the fall and winter, as the company's upcoming results will likely make or break the GameStop investment case.